Why Polish Paper Looks Like a Pretty Play

The yields are lofty enough to outweigh the substantial risks

It has been little more than a decade since Poland shed communism and set out to become a prosperous, market economy. The country has made rapid progress. Thousands of private companies have emerged, and the middle class is growing. The economy is projected to gain 4.6% this year. That's better than last year's 4.4%--though a tad slow by Polish standards as the global slowdown bites. Inflation is expected to fall by a quarter, to less than 7%. Productivity is growing about 9% a year, and foreign investment is strong.

Yet by one crucial measure, Poland is still an emerging market. At 12.3%, returns on Poland's five-year, zloty-denominated government bonds compare to Brazil's and far surpass those of the European Union or the U.S. The rate reflects the uncertainties of an untested market. But savvy investors say risks keep shrinking. That creates opportunity.

Poland's economy is still a work in progress, but the Poles hope to join the EU by 2005 and European Monetary Union before the end of the decade. Poland's high-yield bonds thus become a classic convergence play--a market opportunity that hasn't happened since the second half of the 1990s, when the countries of Southern Europe, then the EU's high-inflation holdouts, were preparing for the single currency. As those economies fell into line with the rigorous EMU criteria, their interest rates and inflation fell, driving up the price of their old high-yield debt, as investors sought its high coupon.

Poland offers even more profit potential because its rates are much higher than Italy's and Spain's were when the EMU countdown started. Poland may not qualify for the euro for eight years. But that hasn't deterred foreign insurers, mutual funds, and hedge funds, which have gobbled up more than $1 billion of Polish government paper this year. Foreigners buy twice as much Polish debt each month as they did last year.

With stocks falling and euro zone bond yields at 4.5%, it's no wonder Western European investors love Polish bonds. "We no longer think of Poland as an emerging market," says Marc Kersten, a fund manager specializing in convergence plays for Germany's DWS Investment. "It's in a new asset class between the emerging markets and the G7, where the returns are high and the risks limited. That's why it is so attractive." DWS' European Convergence Bond Fund, which puts 60% of its money into Poland, has pulled in $650 million since its launch in February, 2000.

FEW WORRIES. Poland isn't the only convergence play. The Czech Republic and Hungary are also EU candidates. But their rates are lower because their economies are more developed, so the profit potential is less. Yet Polish bonds aren't risk-free. Currency weakness could erase some profits. The freely traded zloty rose last year against the euro and the dollar, but it's the most volatile East European currency. Another source of instability is an election later this year. The Social Democrats, mainly ex-Communists, are expected to oust the center-right coalition, whose stringent economic policies have pushed the jobless rate to 16%, a six-year high.

But analysts tend to play those problems down. "I'm not worried about the political situation or the outlook for the currency," says Guintaras Chlijious, who follows Poland for Austria's Raiffeisen Zentralbank. "We're still going to see convergence with the EU." The ex-communists are committed to a market economy and EU membership. And the country's improving fundamentals, even with the world slowdown, are expected to stabilize the zloty. "Longer-term, investors shouldn't be too worried," says Charles Robertson, a Central European specialist at ING Barings in London. Clearly, they're not. For bond buyers, Poland's future is almost here.

By David Fairlamb in Frankfurt, with Bogdan Turek in Warsaw

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